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Much Ado About Nothing

November 4, 2015  | by Michael Strauss

Equities | Fixed Income | Market Commentary

Turning black tunnel interior, 3d illustration

Summary

  • Market pundits are obsessing over the timing of the Fed move on interest rates with increasing divergence on “when” but not “if”.
    The reality is that this timing doesn’t really matter – whether it be December, March or somewhere in between.
    A strong rebound in equities in October, combined with the Fed’s upgraded assessment of global economic conditions, suggests that our central bankers are not afraid of the markets and the markets are not afraid of the Fed.
    Net, we still look for the policy-setting compromise for the future direction of monetary policy to be a low and slow normalization process that will likely be comprised of 25 basis point rate hikes every two or three FOMC meetings for the next 12 to 15 months and only if the incoming data support this action.

Moving Closer to Liftoff

The FOMC held monetary policy steady at late October meeting, with Jeffrey Lacker (the President of the FRB-Richmond) providing the one dissenting vote for an immediate 25 basis point rate hike. Despite the deceleration in real GDP in 2015:Q3, key domestic demand components were solid as real final sales rose three percent. Accordingly, the FOMC provided hints that they might not wait as long as financial market participants were anticipating (March 2016) before starting the normalization process.

Net, the Fed downgraded its concerns about the economic challenges outside the U.S., which was eventually correctly perceived as a favorable development for risk assets.

Softer GDP, but Spending Remains Solid

The first reading for real GDP growth for 2015:Q3 revealed a deceleration in economic activity to a 1.5 percent pace, down from the 3.9 percent advance in 2015:Q2. However, the key domestic demand components were solid as real final sales rose 3 percent. Despite the pessimistic perception that developed after the renminbi devaluation and sharp global equity market selloff in August, real consumption spending rose 3.2 percent, residential investment outlays gained 6.1 percent, and nonresidential investment (even with a hit from the energy complex) rose 2.1 percent.  The weak link in the GDP report was a close to $57 billion drag from inventories due in part to the stronger than expected consumer and business demand which depleted inventories. Net, the economy was stronger than the headline print and monetary policy officials will focus on the solid 3.2 percent gain in real private domestic demand.

Changing of the Guard

With the turn of the calendar to 2016, a new group of regional Federal Reserve Bank presidents will become voters on the FOMC. Although all 12 Fed presidents partake in each FOMC meeting and have an equal opportunity to voice their views on the direction of economic activity and monetary policy, only five of the president’s vote at each meeting.

In comparison to the current group, the 2016 policy voters have a significantly more hawkish bias and a more positive view on structural economic conditions which could increase the probability of the Fed starting the normalization process in late January if they haven’t already done so. FRB-Cleveland President Mester, a policy hawk, replaces FRB-Chicago President Evans who is one of the staunchest doves. FRB-Kansas City President George, a hardline hawk, replaces FRB-San Francisco President Williams, a dove. FRB-St Louis President Bullard, a hawk, replaces FRB-Atlanta President Lockhart, a moderate. Finally, FRB-Boston President Rosengren, a dove, takes over for FRB-Richmond President Lacker, a hawk who has recently dissented in favor of the start of the normalization process. Net, three hawks and a dove will replace one hawk, two doves, and a moderate. This “changing of the guard” at the Fed may further lower the bar for our monetary policy leaders to begin to normalize the Fed funds rate next year for the right economic reasons.

The hawkish tilt from next year’s crop of voting regional bank presidents will be partially offset by the fact that the overwhelming majority of the Board of Governors are in the dove camp. Net, we still look for the policy-setting compromise for the future direction of monetary policy to be a low and slow normalization process that will likely be comprised of 25 basis point rate hikes every two or three FOMC meetings for the next 12 to 15 months and only if the incoming data support this action. In the latest week many market participants have finally joined us and reduced their fear of the Fed. As we have stressed on several occasions, since World War II a low and slow policy adjustment for the Fed has typically been met with modest continued gains in the equity market.

Climbing Back Up the Waterfall

As a follow-up to our commentary last month (After the Waterfall), the stock market, in a similar fashion to what unfolded back in 1998 and 2011, staged a sharp rebound the last month and has climbed back up the waterfall that unfolded in late August when the S&P 500 Index dropped more than 12 percent in four days. Appeasing comments for additional stimulus out of Europe and Japan, as well as another round of easing by Chinese officials, helped to improve many of the global equity markets as well. However, the U.S. stock market was the star performer, aided by good news out of bell-weather stocks in the technology sector and continued signs that domestic consumer and business spending and investment activity outside of the energy sector remained strong.

The third quarter earnings season is more than halfway done. Investors had feared that the impact of the global slowdown on domestic earnings would be severe and at first glance that may appear to be true. However, the hardest hit sectors, energy and materials, are responsible for almost all of the headline weakness in the current earnings reporting season. A closer look reveals that over 62 percent of companies have reported an increase in earnings and 75 percent of companies have exceeded their initial earnings estimates. Net a portion of close to 8.5 percent rebound in the S&P 500 Index in October was driven by better earnings. Moreover, it is important to recognize that the weakness in commodities, namely oil, began in the fourth quarter of 2014 when OPEC opted not to cut production. The earnings impact of the weakness in the energy complex should be close to fully realized at the end of this quarter and earnings comparisons will be easier as we move into 2016. In related markets, the TED spread, which has often been viewed as a sign of potential stress in the financial system and widened six basis points to 34 basis points in the third quarter, narrowed about 8 basis points in October. Likewise, high yield credit spreads narrowed almost 70 basis points in the latest month.

Where Do We Go From Here?

We still favor equities over bonds, but the latest month-long rally in stocks provides an opportunity to trim some of the overweight to the strong U.S. and Japanese equity markets and reduce an underweight in Europe. We continue to favor underweights to commodities, emerging market producers, and fixed income securities (including duration). We believe that volatility is reverting back to normal levels which should improve the environment for active management. Likewise, valuations in the capital markets should move back in line with underlying fundamentals in the upcoming months. We caution investors not to get caught up in the “when” regarding Fed policy but rather the “why”. If rates are normalizing because economic conditions are strong enough to support such as move, that should be good for risk assets. There may be short term market indigestion, but with history as our guide, a slow and steady return to a neutral rate policy is not a negative for equity markets.

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Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.